Restaurant Stocks: The Next Market Bubble?

by Will Ashworth | April 4, 2014 9:59 am

There’s a lot of talk at the moment about both a biotech bubble and a tech bubble. In some ways, it’s like we’re back in 1999[1] when anything with a pulse was racing to the moon. (Of course, in hindsight, we all know what happened next.)

A select group of restaurant stocks — not all, mind you — have outperformed their peers as well as the S&P 500 by a country mile over the past year. This success is fueling the IPO fire with several growth stories that have recently gone public or are planning to do so in the near future.

All of this speculative action begs the question: Can these restaurant stocks keep it up in 2014 and beyond, or is a “pop” in the cards? That’s what I’m here to answer.

The Select Few

Restaurant stocks as a group are up 18% through March 31 while the S&P 500 gained 24% in the same period. Year-to-date, restaurant stocks are up a measly 0.4% compared to 2.7% for the index. So, as a group, its performance has been mediocre at best.

But a large number stand out from the rest — as in, at least doubling the index, so, 44% or greater in the past year:

Restaurant Stocks With Total Return of 44%-Plus in the Past 12 Months

Company

TICKER

Total Return

Company

TICKER

Total Return

Sonic

SONC

80%

Red Robin Gourmet Burgers

RRGB

64.4%

Chipotle

CMG

76.7%

Wendy’s

WEN

63.9%

Jack in the Box

JACK

72.9%

Del Frisco’s Restaurant Group

DFRG

61.3%

Buffalo Wild Wings

BWLD

66.7%

Domino’s Pizza

DPZ

53.5%

Fiesta Restaurant Group

FRGI

65.8%

Source: Morningstar

This is a very disparate group of restaurants. If you sat down a year ago to pick some winners in the restaurant space, you never would have been able to capture all nine of these businesses because there’s representation from quick service, fast casual, casual dining, fine dining and even pizza delivery and take-out.

You’ve got a little bit of everything.

Next Page[3]

Usually, when one picks winners, you tend to focus on a segment of the industry you think is going to do well. You might believe that fast casual will outperform, so you pick the best stock of the bunch — in this case it’s Chipotle — and invest in that. I suppose you might go with a second segment such as quick service, but few individual investors would dare to venture much further into restaurant diversification.

Thus, your odds of success, even by investing in the PowerShares Dynamic Leisure and Entertainment Portfolio (PEJ[4]), which currently holds seven of the nine stocks[5] from above, is slim to none because it’s reconstituted four times a year. Most of these names will be gone by the end of the summer.

Valuation Bubble

According to Yahoo Finance, the restaurant industry’s average P/E at the moment is 23.1, whereas the nine companies from above have a multiple of 41.7 — 80% higher than the industry as a whole. At the very least, this difference in valuation suggests these particular stocks might be a little ahead of themselves.

Whether a bubble exists depends on a number of different factors. Let’s take a look at a few individual names to explain:

Sonic (SONC[6]): Sonic, which has the best performance over the past year at 80%, has a P/E of 33.8. Its diluted earnings per share for the second quarter improved by 40% year-over-year to 7 cents. William Blair analyst Sharon Zackfia believes its growth strategy[7] will lead to long-term EPS growth of 20% annually. Not too many restaurant brands are coming anywhere close to this kind of growth. For example, McDonald’s (MCD[8]) — until recently — had been smoking its competitors, and its five-year EPS growth between 2009 and 2013 was still only 8.1%. Investors are willing to pay more for big growth, which is what Sonic is delivering. No bubble in Sonic.

Fiesta Restaurant Group (FRGI[9]): Of the nine restaurants, Fiesta has the highest current P/E ratio at 119. It has caught fire in recent quarters, delivering comparable restaurant sales growth of 7% in Q4 at Pollo Tropical, one of two concepts it operates. In terms of profits, FRGI generated adjusted EPS of 20 cents in the quarter, 67% higher year-over-year. For fiscal 2013, FRGI’s earnings grew by 40% YOY. Fiesta’s results indicate that further growth, especially in its Pollo Tropical concept, is just around the corner. With higher earnings, that P/E multiple will be in the 30s in no time. A bubble it’s not.

Chipotle Mexican Grill (CMG[10]): CMG stock has a price-to-sales ratio of 5.5, more than double any of the others. The business media constantly writes about Chipotle’s overvaluation, a recent example of which is Timothy Green’s March 31 article[11] for Motley Fool. He lays out a compelling case why investors are ignoring the issues that make it a bubble stock. While a P/E of 54 does make one think twice about valuation, comparing CMG to Panera Bread (PNRA[12]) is a poor example. These two businesses have very little in common. Panera Bread (in my opinion) is a god-awful place[13] whose stock has done well, although not in recent years. He’d be better served comparing it to FRGI, which sells the same kind of food at similar or slightly lower prices.

I Could Go On

Go through all nine of these stocks and really take a good look at each of their businesses — assessing their pros and cons — and I think you’ll find most if not all of them are performing exceptionally well from an operational standpoint. Investors have simply voted with their wallets as to which concepts are the winners over the past year in the restaurant industry.

Talk all you want about a bubble, but from where I sit I see a bunch of stocks that are dear in price because investors are afraid of the old saying, “Pay peanuts, get monkeys.” With U.S. stocks into the sixth year of a bull run, owning quality has become even more important.

seven of the nine stocks: https://www.invesco.com/portal/site/us/financial-professional/etfs/holdings/?javax.portlet.endCacheTok=com.vignette.cachetoken&javax.portlet.pst=72e337bf3b31ef1a015fe531524e2ca0_&javax.portlet.begCacheTok=com.vignette.cachetoken&javax.portlet.prp_72e337bf3b31ef1a015fe531524e2ca0_ticker=PEJ